In the last few days, the European Presidency has published two versions of the draft "Proposal for a Directive of the European Parliament and of the Council amending the [Prospectus Directive] and the [Solvency II Directive]" (Omnibus II). It is clear from these drafts that the Presidency, and some Member States, are prepared to move the Solvency II implementation date back to 1 January 2014. That will create problems for some insurers. It will also be unpopular at the Financial Services Authority (FSA).

The FSA's Omnibus II update gives a hint of that reticence. It describes European Council level negotiations, which include bifurcation and derogation proposals. If adopted, some of those proposals could also lead to the implementation of Solvency II on 1 January 2014. Nonetheless, the FSA is still working towards implementation on 1 January 2013.

Omnibus II - The Presidency's compromise drafts of the Omnibus II directive

The European Presidency has published two updating versions of the compromise draft Omnibus II directive - the first on 21 June 2011, the second on 24 June. If the latest text is adopted by the European Parliament and Council, it will amend the Solvency II directive and change the Solvency II implementation timetable.

Unfortunately, we will not know whether the Parliament and Council will adopt the latest text until at least January 2013. In the meantime, European Council level negotiations are continuing and another compromise text is likely to emerge in the third quarter of 2011.

In summary, the 24 June compromise text:

  • Will help to advance the "Single European Handbook for Insurance Supervision" project. This project began in 2009 when the Commission adopted three Regulations to establish the European System of Financial Supervisors. The early drafts of the Omnibus II Directive left a number of issues to the discretion of Member States and their regulators, but required or empowered the European Insurance and Occupational Pensions Authority (EIOPA) or the European Commission to gradually occupy some of those spaces. As Omnibus II has developed, it has gradually extended these requirements and powers so that, over time, rather more will fall into the Single European Handbook than the earlier drafts envisaged.
  • Inserts a new article (3a) into the Solvency II Directive. Under that article, an insurer in run-off by 1 January 2014 will fall outside Solvency II until 31 December 2016 if
    • The insurer's regulator is satisfied that its run-off will be completed before the end of 2016; and
    • The insurer submits an annual report to its regulator which describes its progress towards that end.

A firm that is subject to Solvency II's reorganisation and winding up provisions will also fall outside Solvency II, but in that case, the transitional period will last until 31 December 2018. Each of these transitional periods can be revoked, and Solvency II applied, if the insurer's regulator no longer believes run-off will complete before the transitional period expires.

We anticipate that most Member States will continue to apply their current regime to these insurers during the transitional period, but that outcome is not yet certain.

  • Gives insurers that meet the current directives' "required solvency margin" on 31 December 2013 up to a year to meet Solvency II's "solvency capital requirement" (SCR). An insurer that relies on this transitional provision must submit a quarterly progress report to its regulator. This report must evidence what the insurer has done to establish "own funds" to cover their SCR or reduce its risk profile to ensure compliance with the SCR by the end of 2014.
  • Fixes the transitional periods for third country equivalence. The result is that third countries that do not have Solvency II equivalent regimes will be treated as if they have, for "reinsurance", "third country group" and "third country group supervision", if certain tests are met. Previous drafts of the Omnibus II directive have included a transitional arrangement that would have had the same effect, but the arrangement was expressed as being capable of lasting for up to five years.

This transitional arrangement may be used, for example, to ensure that Japan, Switzerland, Bermuda and the United States are regarded as Solvency II equivalent, even if their equivalence cannot be determined before the new regime begins.

  • Perhaps surprisingly, retains some complicated transitional arrangements that will require firms to use weighted averages for certain calculations, where the weight increases over the five or seven year period that follows Solvency II implementation. By way of example, for equities purchased on or before 31 December 3013, when an insurer calculates the equity risk sub-module in accordance with the standard forumula using the Omnibus II transitional provisions instead of the main Solvency II rules, and without the option in article 304 of the Solvency II directive, it will be required to calculate the standard parameters as the weighted averages of:
    • The standard parameter to be used when calculating the equity risk sub-module in accordance with article 304; and
    • The standard parameter to be used when calculating the equity risk sub-module without the option in article 304

However, the weight for the parameter must increase at least linearly at the end of each year from 0% during the year starting on 1 January 2014 to 100% five years later.

  • Re-staggers Solvency II implementation so that Member States must:
    • Adopt and publish their Solvency II implementing laws by 31 March 2013.
    • Apply Solvency II to firms domiciled in their territory from 1 January 2014.
    • Give their supervisory authorities the power, between 1 July and 31 December 2013, to consider and make decisions on:
      • Applications for supervisory approval of ancillary own funds;
      • The appropriate classification of own-fund items that fall outside the list provided by Solvency II. Omnibus II especially envisages decisions on subordinated mutual member accounts, preference shares and subordinated liabilities entered into before 1 January 2014 in accordance with the rules that implement the existing insurance directives in the relevant Member State;
      • Applications to use undertaking specific parameters when calculating the life, non-life and health underwriting modules of the standard formula;
      • Applications for approval to use a full or partial internal model;
      • Applications to establish insurance special purpose vehicles; and
      • Applications to use a group internal model.
  • Requires firms to submit an implementation plan to their supervisor by 1 July 2013, which evidences their progress towards Solvency II compliance. In particular, the plan should include information about the firm's technical provisions, eligible own funds, capital requirements, systems of governance and processes and procedures for supervisory reporting and public disclosure.  

The FSA's June 2011 Omnibus II update

On 27 June 2011, the FSA updated the Omnibus II part of its website.

The FSA update describes two particular proposals that have been discussed at European Council level under the Hungarian Presidency. In particular:

  • Bifurcation of the directive: under this proposal the responsibilities of supervisors and EIOPA would still be "switched on" from 1 January 2013 and Solvency II transposition would have to be complete by that date. However, Solvency II would not be switched on for firms until 1 January 2014. During 2013, firms would be regulated under their Member State's existing regime but their progress towards Solvency II compliance will be monitored.

If this proposal is adopted, firms will be required to prepare and submit their Solvency II reports during 2013 on a "best efforts" basis. Alternatively, firms will be required to report on a full Solvency II basis. In each case, it is (perhaps) implied that the purpose of the reporting is the same: to ensure Solvency II compliance by year end.

  • Derogation of the SCR for one year from 1 January 2013: Solvency II would go live as expected on 1 January 2013, but firms could derogate their SCR in the first year without disclosing this to the market. However, the firm would have to notify its regulator and submit a recovery plan which, if approved, would effectively allow the firm until 1 January 2014 to meet its SCR.

There are many similarities between these proposals and those set out in the Presidency's latest compromise draft text. It is therefore possible that the FSA's update was intended to pre-empt rather than gloss the Presidency's compromise texts, but the timing and drafting have gone awry.

The FSA goes on to explain that "there is no agreement on any of these proposals... consequently, we continue to work on the assumption that the implementation date is 1 January 2013". It also states that "a number of specific transitionals have also been proposed and are subject to the same European policy adoption process. As such firms should continue their preparations, making clear assumptions and building flexibility into their plans so they can update them as more information becomes available".

Analysis

This seems very unsatisfactory from a firm perspective. No doubt it is equally unsatisfactory from the FSA's perspective. Firms and the FSA have worked hard and incurred significant expense to prepare for implementation in January 2013 and that goal seems to be slipping away.

While a delay will provide welcome respite for some firms and some Member States, it "punishes" those that planned and incurred the extra costs required to ensure they would implement on time. If those firms and Member States had known that an extra year would become available, they might well have been able to prepare for implementation using existing resources, instead of retaining additional resource at significant expense to ensure "unnecessarily early" compliance.

Those firms and Member States may also face additional costs as they try to keep their project teams and Solvency II specialists engaged in the development and implementation process - a process that is likely to last longer than anticipated and is already battling severe implementation fatigue. These problems will only be compounded if the European Authorities or other Member States use these delays to reopen policy issues that were thought to have been settled when the Solvency II directive was adopted in late 2009.

These delays, if agreed, will also undermine the credibility of the European Authorities, and the European Commission in particular. Despite significant pressure from some Member States and industry groups, the Commission has repeatedly (and very recently) insisted that Solvency II will be implemented on 1 January 2013. For that reason, the European Authorities and some Member State Supervisory Authorities have taken every reasonable opportunity to press firms to organise themselves for (and to incur the costs of) timely implementation.

The FSA, of course, now has other problems to contend with. The proposed delay means that it will bedifficult or impossible for it to complete the UK's Solvency II implementation work before its powers pass to the Prudential Regulatory Authority. It would have been easier and more cost effective if Solvency II implementation was completed well before the formal handover begins.

The FSA will also have to reassess its approach to "Individual Capital Assessments" (ICA) and "Individual Capital Guidance" (ICG) under the current regime. At the moment, firms are expected to carry out regular ICAs, but they are no longer expected to report them in any detail to the FSA, and ICG is unlikely to be given to many firms during the final Solvency II implementation phase. The FSA will now have to decide whether it can and should fully re-implement these processes to mitigate the risks that a Solvency II implementation delay will bring.

Finally, of course, UK firms will continue to operate on a European Economic Area playing field that is far from even - Solvency II is designed to enhance the single market and make the regulatory regime across Europe more cohesive and more consistent. Policyholders will have to cope with an EU-wide regulatory system which the European Authorities have effectively told us no longer provides adequate consumer protection. And we will have to hope for the best from a financial stability perspective - the third objective for Solvency II is to enhance financial stability.

Little wonder, then, that the FSA's website implies that it will do all it reasonably can to retain the 1 January 2013 implementation date. As the European Presidency states, in the cover notes to each of the latest drafts "further work by the Commission and the Member States is required, in particular, on ...the delay in the date of application of the Solvency II regime".

What can firms do in the meantime?

It would be a very brave man who suggested that firms could relax at this point. The FSA (and perhaps the Commission) may retain the 1 January 2013 implementation date; and many UK firms and consumers would like them to do so.

At the same time, there are so many variables that even those Member States that are pushing for a delay cannot be sure they will succeed.

Unsatisfactory though it is, firms must therefore heed the FSA's advice:

  • Assume (for the time being) that the implementation date will still be 1 January 2013.
  • Continue preparations, making clear assumptions and building flexibility into implementation plans so they can be updated as more information becomes available.

Notwithstanding the fact that the FSA is in an incredibly difficult position, firms should also press it to do better than meet its commitment to "assess... the impact of the draft proposals and... continue to provide further clarification when [there is] greater degree of certainty...". If a delay becomes inevitable, firms will be able to save significant costs if that is made clear sooner rather than later.

In the meantime, Wragge & Co's insurance, corporate and regulatory specialists can advise insurers on each of these issues and many others. More information about their work in the sector is available online under the firm's insurance sector expertise.